We often call managed futures a long volatility investment, and it is well documented how well managed futures have done when stocks fall. It has also become a bit of norm for some managed futures managers to blame poor recent performance on a falling VIX.
But our friends at Chadwick Investment Group are out with a short research piece talking about how the VIX doesn’t really get the job done for analyzing whether the volatility environment is good or bad for managed futures:
“Stock index volatility might be high or low, but this means little if you are trading currencies, agricultural commodities or other market sectors. Looking at market risk over a wide range of markets, offers significantly more insight on current market conditions.”
The rest of their piece is a nice ‘back to the basics’ look at how volatility in multiple markets affects trend following returns, including some charts showing global volatility back near pre-crisis 2007 levels. Here’s to hoping that is a spring being loaded up with tension about to pop like it did in 2008…
In today’s low volatility environment we are seldom reminded of the benefits and uses of volatility. Today, both interest rates and market volatility are approaching record lows. Many investors are expecting consistent returns as major indexes advance higher. Even more are being lulled to sleep with the decreasing volatility that accompanies an advancing equity market.
Volatility and Market Indexes
Investors commonly think of stock market volatility in terms of the VIX. The Chicago Board Options Exchange’s Market Volatility Index, or the VIX, measures the implied volatility of S&P 500 index[i]. The VIX represents the market’s expectation of volatility in equities over the next 30 days. Higher VIX values indicate anticipation of higher stock market volatility while lower VIX values indicate the expectation for lower stock market volatility.
Equity prices and VIX values work in opposition. Higher VIX values point to lower equity prices while lower VIX prices signal an advancing market. This inverse relationship can be seen through the correlation coefficient between the S&P 500 and the VIX. From January 2000 to March 2013 the correlation of the two is -0.8790. This fact, while easily overlooked, is detrimental to traditional long only investors. Investors who are long market indexes will near certainly suffer losses with higher VIX values.(Disclaimer: Past performance is not necessarily indicative of future results.)
From January 1, 2000 through March 15, 2013 the VIX fluctuated from a low of 9.39 on December 15, 2006 to a high of 89.53 on October 24, 2008. At the time of writing (June 2013) the VIX is trading at approximately 16.00.
The limitation of the VIX is that it looks at one market sector only, the S&P 500 which represents the 500 largest companies in the United States. Stock index volatility might be high or low, but this means little if you are trading currencies, agricultural commodities or other market sectors. Looking at market risk over a wide range of markets, offers significantly more insight on current market conditions. To illustrate we will sample volatility of many market sectors at one time and create an index. This index will provide a comparison of current and historical market volatility across a broad range of markets.
To prepare our index we will first select several markets per market sector for a total of 28 markets. Market sectors used are currencies (5), agricultural markets (10), energies (3), bonds (5), metals (2), and stock indexes (3). Then we calculate the weekly trading range of each market and translate this into dollars using the market’s corresponding point value. For example if Corn moved 22 cent in the previous week, then the dollar value of this movement is $1,100 (22 cent * $50 = $1,100). Values are summed within each sector to reveal the dollar equivalent of last week’s market movement. Values are indexed to the first data point, and today’s value is expressed as the percentage move from the first data point. Using a starting value of $1,000 we divide the capital evenly across all sectors so that one sector is not favored over another.
For our calculations it is critical to understand that our index of volatility expresses market movement. As shown above, higher VIX values point to lower equity prices. Our expression of volatility records market movement, which can be either higher or lower.
You might assume that global market risk remains in a relatively consistent over time, or channel bound. There will be short lived peaks and valleys, but one market’s low volatility will counter against another market’s high, especially given a large enough sample of markets. This is far from reality; in fact our global volatility value fluctuated greatly from May 2000 through May 2013. The chart below demonstrates that there are indeed times when everything is moving wildly either higher or lower.
(Disclaimer: Past performance is not necessarily indicative of future results.)
Volatility and Trend Following Performance
One group of traders, Trend followers, traditionally benefit from increasing volatility while other programs experience losses. History reveals movement from low volatility to higher volatility produces outsized trend following returns. To demonstrate an index of trend following programs[i] was created from January 2000 to May 2013. We compared this index to a monthly chart of the Global Volatility, as calculated previously.(Disclaimer: Past performance is not necessarily indicative of future results.)
In the chart above Global Volatility values are represented by a dotted line. Increases in volatility coincide with peaks in performance. For example looking at July 2007 reveals a substantial increase in volatility lasting until December 2008. Increases in volatility were met with increased performance from the Trend Following Index. Periods of declining Global Volatility represent the inverse. For example, declines in volatility from August 2011 through April 2013 highlight the weak performance in the Trend Following Index. Correlation data from May 2000 through May 2013 (using monthly data) confirms chart observations. Correlation data over this period is 0.8100 indicating high correlation between the two data sets.
Why do volatility increases result in higher Trend Following performance?
Why do periods of increased volatility coincide with outpaced Trend Following performance? While trend followers, in the simplest terms, buy markets moving higher and sell short market moving lower, their true advantage is money management. Most trend followers allocate contracts using a fixed fractional trading allocation based on market risk.
Fixed fractional traders use a fixed percentage of a trading account on each trade. For instance an account with $100,000 might risk 2% for each position it takes or $2,000. If the account balance increases to $150,000 then risk dollars would change to $3,000 while the risk percent remains at 2%. Risk dollars are dynamic, they will fluctuate with the balance in the account however the risk percent is static.
Contract allocation, the number of contracts to trade per position, is generated by using the market risk of a trade. Assume a contract has market risk of $1,000; you are willing to risk $1,000 per contract before accepting a loss. To determine the number of contracts to trade, take the fixed risk of the account and divide it by market risk. Using $100,000 as a starting point and 2% risk we can quickly determine contracts to trade based on market risk. Market risk of $1,000 would indicate two contracts to trade on this position ($2,000/$1,000 = 2 contracts). Two contracts represent 2% risk for the account.
If market risk increases to $1,500 then the number of contracts to trade would be one rather than two ($2,000/$1,500 = 1.33 rounded down to 1 contract). If market risk decreases to $500 then the number of contracts to trade would be four rather than the two ($2,000/$500 = 4 contracts). Since many trend followers use market volatility to set market risk, lower market volatility increases the number of contracts traded on each position. Account risk remains the same; however the number of contracts used to generate the risk increases. The approach spreads risk evenly across markets.
The Trend Following Payoff Curve
The similarities of the Long Option positions and Trend Following money management are striking (Long options are ones purchased not sold short). Buying an option presents limited risk because your risk is limited to the price paid for the option. Long call options benefit from moves higher in price while long puts benefit from moves lower in price.
Trading contracts using a fixed risk of your account is similar to the premium paid for an option. (The difference being that stops may not limit your risk to 2%, while the premium paid for an option does.) Both long options and trend following position have the ability for large outpaced and near unlimited reward. However risk and return similarities do not stop at risk or potential payoff.
(Disclaimer: Past performance is not necessarily indicative of future results.)
Long option positions placed in periods of low volatility benefit from price movement in a positive direction and from increased volatility. Assume you are long a market at 100 and it typically moves two points per day. If tomorrow the market began moving up at four points a day then profits accumulate faster. If the market begins moving advancing six points a day then profits accumulate even faster still. Both Trend Followers and long option traders benefit from the fast market movement and volatility rewards each. Low volatility affords Trend Followers the ability for more contracts for each unit of risk. When volatility explodes, more contracts create outsized returns.
Movements in volatility and trend following performance are heavily correlated. Investors can use this insight to time entry, or to add money into Trend Following programs by looking at the volatility over a wide basket of markets. High volatility periods offer opportunities to lighten up or decrease exposure in Trend Following programs as movement from high to low volatility are times of losses for these types of programs.
 S&P 500 Index ® – The S&P 500 Index ® is an equity index created from the prices of 500 large-cap common stocks actively traded in the United States. S&P 500 ® is a trademark of The McGraw-Hill Companies.
 Components of the Trend Following Index are: Abraham Trading Company, Diversified Program, Chesapeake Capital Corporation, Diversified Program, Dunn Capital Management, World Monetary Assets System, Eckhardt Trading Company, Standard Plus Program, EMC Capital Management, Classic Program, Hawksbill Capital Management, Global Diversified Program, Winton Capital Management, Diversified Trading Program